Understanding Tax Issues Related to Shareholder Loans

Owners occasionally borrow funds from their businesses. If your company has extra cash on hand, a shareholder loan can be a convenient and low-cost option — but it’s important to treat the transaction as a bona fide loan. If you don’t, the IRS may claim the shareholder received a taxable dividend or compensation payment rather than a loan. Here’s more information to protect shareholder advances from IRS scrutiny.

A closer look at AFRs

You can make de minimis loans of $10,000 or less to shareholders without paying interest. But, if all of the loans from the business to a shareholder add up to more than $10,000, the advances may be subject to a complicated set of below-market interest rules unless you charge what the IRS considers an “adequate” rate of interest. Each month the IRS publishes its applicable federal rates (AFRs), which vary depending on the term of the loan.

Right now, interest rates are near historical lows, making it a good time to borrow money. For example, in January 2017, the adjusted AFR for short-term loans (of not more than three years) was only 0.96%. The rate increased to 1.97% for mid-term loans (with terms ranging from three years to not more than nine years). Both rates are probably below what a bank would charge. As long as the company charged interest at the AFR (or higher), the loan would be exempt from the complicated below-market interest rules the IRS imposes.

The interest rate for a demand loan — which is payable whenever the company wants to collect it — isn’t fixed when the loan is set up. Instead, it varies depending on market conditions. So, calculating the correct AFR for a demand loan is more complicated than it is for a term loan. In general, it’s easier to administer a shareholder loan with a prescribed term than a demand note.

Below-market loans

If your company lends money to an owner at an interest rate that’s below the AFR, the IRS requires it to impute interest under the below-market interest rules. These calculations can be complicated. The amount of incremental imputed interest (beyond what the company already charges the shareholder) depends on when the loan was set up and whether it’s a demand or term loan.

Additionally, the IRS may argue that the loan should be reclassified as either a dividend or additional compensation. The company may deduct the latter, but it will also be subject to payroll taxes. Both dividends and additional compensation would be taxable income to the shareholder personally, however.

Bona fide loans

When deciding whether payments made to shareholders qualify as bona fide loans, the IRS considers:

The size of the loan,

The company’s earnings and dividend-paying history,

Provisions in the shareholders’ agreement about limits on amounts that can be advanced to owners,

Loan repayment history,

The shareholder’s ability to repay the loan, based on his or her annual compensation, and

The shareholder’s level of control over the company’s decision making.

The IRS will also factor in whether you’ve executed a formal, written note that specifies all of the repayment terms. The loan contract should spell out such details as the interest rate, a maturity date, any collateral pledged to secure the loan and a repayment schedule. Please note, that in addition to the risk that the IRS may treat it as a taxable dividend or compensation payment, an S Corporation is required to make prorate distributions to its owner. If an owner’s loan is reclassed as a distributive in an S Corporation with multiple owners, the entity is at risk of violating the S Corporation rules and being treated as a C Corporation.

Getting started

If you’d like to take advantage of today’s low-interest rates, a shareholder loan could be a smart tax planning move to make. Contact your MarksNelson professional for more information.

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